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Linn Energy
is the eighth-biggest master limited partnership in the U.S., and the largest focused on energy production. Based in Houston, the company has grown rapidly through acquisitions since its initial public offering in 2006, by purchasing long-lived energy fields in states such as Texas, Oklahoma, and Kansas.

Linn (ticker: LINE) hedges all of its oil and natural-gas output with financial derivatives, the better to provide a steadily growing level of income to unit holders. The company pays an annualized distribution—the MLP equivalent of a dividend—of $2.90 per unit, which equates to a yield of 8%, based on its current share price of $36.

Moreover, Linn may be overstating the cash flow available for distribution, by not deducting the cost of financial derivatives—mainly put options—from its realized gains on hedging activities in its quarterly results. Bears argue that funds invested in derivatives should be treated as an expense, and at least one of Linn's major competitors follows that approach. Linn says its energy derivatives are an integral part of its corporate strategy and amount to an asset, much like an oil and gas property. The value of such assets typically gets depreciated over their useful life.

In a statement provided to Barron's last week, Linn said, "Nobody disputes that 'depreciation' of oil and gas assets should be deducted from Ebitda [earnings before interest, taxes, depreciation, and amortization] or distributable cash flow because it is a 'capital' expense, and we view puts the same way."

In the same statement, Linn expressed confidence "in the validity and accuracy" of its financial reporting.

Wall Street analysts have ignored the derivatives issue until now. Thirteen of the 18 analysts who follow the company rate it Buy, and bulls note that Linn's energy production, including oil, gas, and natural-gas liquids, more than doubled in last year's third quarter, to the equivalent of 782 million cubic feet per day.

What's In the Pipeline?

Hedging gains account for a big chunk of Linn's distributable cash flow and support its 8% yield. But there may be less to the gains than meets the eye.

LINN ENERGY at a Glance

Unit Price

$35.93

52-Week Change

-1.8%

2012 Dist. Cash per Unit *

$3.11

Distribution Rate per Unit

$2.90

Yield

8.0%

Market Value

$8.4 billion

Net Debt

$5.5 billion

*Linn's projection of distributable cash flow

2010

2011

2012**

DistrIbutable Cash Flow (mil)

$457

590

503

Realized Hedging Gain (mil)

$308

230

281

**First nine months of 2012.

Sources: Bloomberg; company reports

But David Amoss, an analyst at Howard Weil, broke ranks on Friday and downgraded Linn to Sector Perform from Outperform, citing the company's treatment of its hedging costs. Amoss cut his estimate of 2013 distributable cash flow to $2.45 per unit from $3.03, "to better reflect the underlying cost of the hedges" that he estimates at $120 million annually, he wrote in a client note. Linn might have to make accretive acquisitions this year to cover its $2.90 distribution, he added. Alternately, it is possible the distribution could be cut. Linn shares fell 3.8% on Friday, but still trade for two times book value.

Linn has projected distributable cash flow of $684 million, or $3.31 a share, for 2012. It is due to report fourth-quarter results on Thursday.

Hedging gains contribute a sizable percentage of Linn's distributable cash flow. The company spent $583 million on derivatives purchases in the first nine months of 2012, and hedging gains in that period totaled $281 million, or 55% of distributable cash flow of $503 million. The company's financial reports don't break out the derivatives costs that are included in gains, but Linn's history of derivatives purchases suggests annual costs of $100 million to $150 million. Amoss' $120 million estimate is squarely in that range.

Linn expenses the cost of puts and other derivatives over a multiyear period when calculating net income, as mandated by accounting rules. But it doesn't deduct such costs from distributable cash flow, a financial measure that isn't compiled in accordance with GAAP, or generally accepted accounting principles. This means companies have leeway in making the latter calculations. Usually, they subtract interest expense and maintenance capital expenditures from gross cash flow to derive the amount of cash available to be distributed to holders.

While net income is the most common financial yardstick for corporations, it can be of little use in evaluating MLPs, particularly partnerships like Linn that make heavy use of derivatives for hedging. Quarterly changes in the value of a multiyear hedge portfolios can overwhelm and distort operating results.

Linn reported a net loss of $430 million in the third quarter, for instance. But it determined that distributable cash flow totalled $202 million. The discrepancy was caused primarily by $520 million of unrealized losses in its derivatives book, which occurred in a quarter when energy prices rose.

LINN'S DERIVATIVES PORTFOLIO has insulated the company from a weak natural-gas market, and allowed it to pay a steadily rising distribution. In the third quarter, it received a price of $2.71 per thousand cubic feet for its natural gas, but realized more than $5 per Mcf after accounting for hedging gains.

MLPs and other energy companies can use swaps or purchase put options to lock in future oil and gas prices. (Puts give the holder the right to sell a security or commodity at a fixed price by a predetermined date.) Some companies prefer swaps to puts because puts are more expensive. Most swaps are executed "at the money," meaning they are based on future oil and gas prices implied in the futures market. The advantage of a put is that the holder gets upside above the put price.

It appears from Linn's financial statements that the company bought a considerable amount of in-the-money put options on natural gas last year. These are more expensive than at-the-money puts. Specifically, Linn bought a lot of puts struck at $5 per Mcf from 2013 through 2017 at a time when the "strip" (the average price for that five-year period) was in the $4 to $4.50 range. The puts would have had an intrinsic value of 50 cents or more. Gas now trades around $3.15 per Mcf, after averaging $3 in 2012, making the puts more valuable still.

The Bottom Line

Linn shares fell Friday by 3.75%, to $35.93, after an analyst downgraded the stock and lowered his cash-flow estimates. The MLP's units are still richly valued, and could fall further.

The likelihood of such gains explains why Linn spent almost $600 million on derivatives purchases in the nine months ended in September, up from just $134 million in all of 2011. Given Linn's accounting for derivatives, the put purchase prices eventually should be reflected as a hedging gain in cash flow. Linn says last year's hefty derivatives purchases reflected sizable acquisitions. It spent $2.8 billion on energy deals in 2012.

LINN CONTENDS THAT ITS "cost of capital" is one of its main advantages over rival energy producers. Essentially, that means it has a more richly valued stock, which has helped it outbid other companies for oil and gas assets, which in turn have been accretive to cash flow. The company relies on equity offerings and debt to fund acquisitions. A lower share price would hinder its acquisition strategy, and thus, the growth of distributable cash. Linn has ample debt of $5.5 billion, resulting in a junk-grade credit rating from both Moody's and Standard & Poor's.

Given that 5% dividends are available from fortress-like energy companies such as
Royal Dutch Shell
(RDS/A), investors might want to steer clear of riskier bets like Linn. At the very least, Wall Street should start asking harder questions about what Linn calls its "industry-leading hedge program."